Prof Roubini prescribes first aid for America’s economy

As the prospects for the American economy darkens, the discussion turns from “where’s my recession?” to “what should we do?” Prof Nouriel Roubini has similar ideas to those in my post of yesterday, “The last opportunity for effective action before disaster strikes“, developed in greater detail. He has generously allowed this to be reposted here.

It is now clear that the US financial system – and now even the system of financing of the corporate sector – is now in cardiac arrest and at a risk of a systemic financial meltdown. I don’t use these words lightly but at this point we have reached the final 12th step of my February paper on “The Risk of a Systemic Financial Meltdown: 12 Steps to a Financial Disaster” (Step 9 or the collapse of the major broker dealers has already widely occurred).

Thursday a senior market practitioner in a major financial institution wrote to me the following:

So far as I can tell by working the telephones this morning:

LIBOR bid only, no offer.

Commercial paper market shut down, little trading and no issuance.

Corporations have no access to long or short term credit markets — hence they face massive rollover problems.

Brokers are increasingly not dealing with each other.

Even the inter-bank market is ceasing up.

This cannot continue for more than a few days. This is the economic equivalent to cardiac arrest. Then we debated what is necessary to restart the system.

I believe that the government will do another Hail Mary pass, with massive guarantees to the short-term commercial credit system and wide open short-term lending by the Fed (2 or 3 times expansion of the Fed balance sheet). If done on a sufficient scale this action will probably work for a while. But none of these financial measures affects the accelerating recession — which will in turn place more pressure on the financial sector.

Another senior professional in a major global financial institution wrote to me:

Today, in our trading room, I could see the manifestations of a lending freeze, and the funding hiatus for banks and companies, with libor bid only, the commercial paper market closed in effect, and a scramble for cash – really really scary.

Do you think this is treatable without a) a massive coordinated liquidity boost and easing of monetary policy and b) widespread nationalisation of some banks, gtessto others AND a good bank/bad bank policy where some get wiped along with their investors? The Treasury Tarp plan is an irrelevance if we are at a major funding crisis.

… the U.S. economy is “flat on the floor” after a cardiac arrest as companies struggle to secure funding and unemployment increases.

“In my adult lifetime I don’t think I’ve ever seen people as fearful, economically, as they are now,” Buffettsaid today in an interview with Charlie Rose to be broadcast tonight on PBS. “The economy is going to be getting worse for a while.’ …The credit freeze is “sucking blood” from the U.S. economy, Buffett said.

We are indeed at the cardiac arrest stage and at risk of the mother of all bank and non-ban runs as:

(1) The run on the shadow banking system

The run on the shadow banking system is accelerating as: even the surviving major broker dealers (Morgan Stanley and Goldman Sachs) are under severe pressure (Morgan losing over a third of its hedge funds clients); the run on hedge funds is accelerating via massive redemptions and a roll-off of their overnight repo lines; the money market funds are experiencing further withdrawals in spite of government blanket guarantee.

(2) A silent run on the commercial banks

A silent run on the commercial banksis underway. In Q2 of 2008 the FDIC reported $4462bn insured domestic deposits out of $7036 bn total domestic deposits; thus, only 63% of domestic deposits are insured. Thus $ 2574bn of deposits were not insured. Given the risk that many banks – small, regional and national – may go bust (as even large ones such as WaMu and Wachovia went recently bust) there is now a silent run on parts of the banking system.

Deposit insurance formally covers only deposits up to $100000. Thus any individual, small or large business and/or foreign investor or financial institution with more than $100000 in a FDIC insured bank is now legitimately concerned about the safety of its deposits. Even if as likely the deposit insurance limit will be temporarily raised to $250000 by Congress there will still be a whopping $1.9 trillion of uninsured deposits (or 73% of total deposits); thus, a huge mass of uninsured deposits will remain at risk as even small businesses have usually more than $250K of cash while medium sized and large firms as well as any domestic and foreign financial institution or investor with exposure to US banks has average exposure in the millions of dollars. Particularly at risk are the cross border mostly short term interbank lines of US banks with their foreign counterparties that are estimated to be close to $800 billion.

(3) A run on the short term liabilities of the corporate sector

A run on the short term liabilities of the corporate sector is also underway as the commercial paper market has effectively shut down with little trading and no issuance or rollover of such debt while corporations have no access to long or short term credit markets and they are therefore facing massive rollover problems (over $500 billion of rollover of maturing debts in the next 12 months). Indeed, the market for commercial paper plummeted $94.9 billion to $1.6 trillion for the week ended Oct. 1 (and down over $200 billion in the last three weeks). Especially banks and insurers were unable to find buyers for the short-term debt: financial paper accounted for most of the decline, plunging $64.9 billion, or 8.7% in the last week; but now even non-financial corporations are also experiencing severe roll-off in the CP market.

Discount rates for investment-grade non-financial commercial paper spike to 599bp z(basis points) for 60 day maturities. More companies are borrowing against or tapping their revolving credit lines. This is largely due to the dislocation caused in the money markets by the failure of Lehman and the subsequent withdrawals from money market funds, which are some of the biggest providers of liquidity in the short term funding/commercial paper.

Even the largest corporations are at severe stress: AT&T last week was forced to rely on overnight funding for its treasury operations, as lenders were unwilling to provide more long term financing due to fears in money market funds over investor redemption. The CEO said

“It’s loosened up a bit, but it’s day-to-day right now. I mean literally it’s day-to-day in terms of what our access to the capital markets looks like”

Things are much worse for non-investment grade corporations and for small and medium sized businesses. As reported today by Bloomberg:

Rohm & Haas, based in Philadelphia and rated BBB by Standard & Poor’s, is paying 8 basis points for a $750 million revolving line of credit provided by 13 banks, the treasurer said. A basis point is 0.01 percentage point.

As the U.S. House of Representatives prepares to vote on a $700 billion bailout bill passed by the Senate, global credit markets are being squeezed by banks afraid to lend to each other and to even some investment-grade corporate clients. Treasurers are struggling to keep credit lines open so they can pay employees, fund pension benefits and purchase raw materials.

“The banks are really starting to play hardball,” said Jeff Wallace, managing partner at Greenwich Treasury Advisors, a financial consultant in Boulder, Colorado. “They don’t want to give out any more money to people because they don’t have enough capital”. Banks are demanding renegotiation of interest charges or lending terms when “routine” amendments are requested on lines of credit, said Thomas C. Deas Jr., treasurer of Philadelphia- based FMC Corp. and an association board member.

(4) The money markets and interbank markets have shut down

The money markets and interbank markets have shut down as yesterday — despite the Senate passing the bail-out bill — markets were

USD Overnight Libor was still at 268bp after reaching an all-time high of 6.88%;

(a) a silent run on the huge mass of uninsured deposits of the banking system and even a run on some insured deposits are small depositors are scared;

(b) a run on most of the shadow banking system: over 300 non bank mortgage lenders are now bust; the SIVs and conduits are now all bust; the five major brokers dealers are now bust (Bear and Lehman) or still under severe stress even after they have been converted into banks (Merrill, Morgan, Goldman); a run on money market funds; a serious run on hedge funds; a looming refinancing crisis for private equity firms and LBOs);

(c) a run on the short term liabilities of the corporate sector as the commercial paper market has totally frozen (and experiencing a roll-off) while access to medium terms and long term financings for corporations is frozen at a time when hundreds of billions of dollars of maturing debts need to be rolled over;

(d) total seizure of the interbank and money markets.

This is indeed a cardiac arrest for the shadow and non-shadow banking system and for the system of financing of the corporate sector. The shutdown of financing for the corporate system is particularly scary: solvent but illiquid corporations that cannot roll over their maturing debt may now face massive defaults due to this illiquidity. And if the financing of the corporate sectors shuts down and remains shut down the risk of an economic collapse similar to the Great Depression becomes highly likely.

So what needs to be done?

Even several hundreds of billion dollars in emergency liquidity support to the financial system by the Fed and other central banks in the last week alone have not been enough to stop the seizure of liquidity in interbank markets and the shut down of financing for the corporate sector as counterparty risk is now extreme (no one trusts any more in this crisis of confidence even the most reputable and trustworthy financial and corporate counterparties).

Thus, emergency times where we are at risk of a systemic meltdown require emergency measures. These include the following…

(a) Expanded deposit guarantees

A temporary six-month blanket guarantee on all US deposits (not just those below $250k) combined with a rapid triage between insolvent banks that should be quickly closed and distressed but solvent – conditional on liquidity and capital injections – banks that should be rescued. To stop the silent run on the banking system you do need now such blanket guarantee on all (insured and uninsured) deposit regardless of their size.

To minimize lender moral hazard from such action the blanket guarantee needs to be followed by a very rapid triage and shut-down of insolvent institutions to prevent such institutions from gambling for redemption, i.e. acquiring more deposits and making even more risky loans. To limit such moral hazard distortions one can also limit the extended guarantee only to current deposits: i.e. any new deposit above a $100k limit will not be insured.

Of course all the currently uninsured deposits of such insolvent institutions will need to be made whole once such banks are shut down (otherwise the run on uninsured deposits would continue and accelerate). Once the rotten apples (insolvent banks) that are infecting the good apples (the solvent banks) are eliminated the blanket guarantee will be lifted as the uninsured depositors of surviving banks can be assured that the remaining banks (the good apples) will not go bust.

Currently the silent run is triggered by investors and depositors not knowing which banks will go bust and which will survive as the bad apples are mixed in the same dark basket together withthe good apples. The extra fiscal cost of bailing out the uninsured depositors of failed banks can be addressed with FDIC recapitalization or an increase in deposit insurance premia or by whacking further unsecured creditors of failed banks (as the government should have first claim on the remaining assets of failed banks if uninsured depositors are made whole in such banks).

Anything short of this blanket guarantee cum triage will not be enough as the silent run on the banks will soon become a roaring tsunami of an open run. Solution a la Korea 1997 – where the cross border interbank run was solved via a bail-in rather than a bailout of the foreign cross border interbank creditors of Korean banks via an effectively forced conversion of short term interbank lines into one to three years claims guaranteed by the Korean government – would be too risky as such effective capital controls and coercive stretching of maturities of cross border interbank lines would dramatically scare foreign investors placing funds in US banks.

(b) Expanded emergency liquidity

Extension of the emergency liquidity support of the Fed (both TSLF and PDCF) to a broader range of institutions in the shadow banking system, especially those directly providing credit to the corporate sector. The TSLF and PDCF are already available to some non banks (the broker dealers that are primary dealers of the Fed). But two of such broker dealers are gone (Bear and Lehman) and the other three are under stress.

Goldman Sachs, Morgan Stanley, the other primary dealers and the banks that have access to the TSLF and PDCF (and discount window) have massively used these facilities in the last few weeks; but they are hoarding such liquidity and not relending it to other banks, to the thousands of the other members of the shadow banking system and to the corporate sector as they need such liquidity and don’t trust any counterparty. Thus the transmission mechanism of credit policy (the non-traditional Fed liquidity lines) is completely shut down now. Thus, on an emergency basis the TSLF and PDCF need to be extended to other non-bank financial institutions, especially those directly providing credit to the corporate sector such as non-bank finance companies and leasing companies.

To ensure that this liquidity support is effective the Fed may require the borrowing institutions to maintain their level of exposure to the corporate sector (avoid the roll off of commercial paper, of short term credits to corporate and alike). A similar requirement may need to be imposed on all other financial institutions (banks and non bank primary dealers) that are now shutting down or rolling off their exposure to the corporate sector. Of course a crucial triage of the corporate sector is also necessary: those firms that would have ended up into Chapter 11 or 7 even under less extreme financial conditions should not be rescued and thus allowed to go into bankruptcy court.

(c) Triage

Some members of the shadow banking system will not receive such liquidity support of the Fed (hedge funds and private equity funds) as – fairly or unfairly – there is no political sympathy for such institutions. This means that the demise of hundreds – and possibly thousands – of hedge funds will occur as redemptions and roll off of overnight repo financing for leveraged investments will cause a massive liquidity – and thus solvency – crisis for such institutions.

If hundreds of smaller hedge funds collapse the systemic consequences would be limited (even if in the aggregate hedge funds provide significant financing to the corporate sector). If larger and systemically important hedge funds were at risk of failing the Fed will have to engineer a massive private sector bail-in of such hedge funds (a larger scale rescue a la LTCM) where the prime brokers of such funds are forced to maintain repo exposure to such funds rather than be allowed to shut off such exposure.

This is a radical suggestion but the alternative of a Fed liquidity bailout of systemically important hedge fund is not politically feasible given the little sympathy that such funds enjoy in Congress. The refinancing crisis of private equity firms and their LBOs is a longer fuse run as covenant-lite clause and PIK toggles will postpone such financing crisis but make the harder the fall as zombie corporations that postpone restructuring will have a bigger collapse once the financing crisis eventually occurs. But since many of these LBOsshould have never occurred in the first place any financing crisis for such buy-outs should be dealt with in bankruptcy court; no public funds should be used to rescue such LBOs and the reckless private equity firms that designed such schemes.

(d) Direct lending to businesses

Direct lending to the business sector from the Fed via extension of the PDCF and TSLF to the non financial corporate sector. This could include Fed purchases of commercial paper from corporations and other forms of financing of the short term liabilities of the Administration to small businesses secured in appropriate ways. Given the collapse of the corporate CPmarket and the banking system reluctance to provide loans to the corporate sector (credits lines are being shut down) the only alternative to the Fed becoming directly the biggest emergency bank for the corporate sector would be to force the banking system to maintain its exposure to the corporate sector, possibly in exchange for further Fed provision of liquidity to the banking system. The former option may be better than the latter to deal with the looming illiquidity of the corporate sector.

(e) Coodinated central bank action

Have a coordinated 100bps reduction in policy rates by all major advanced economies central bank and, possibly, even some emerging market economies central banks. While this policy rates may not directly resolve the insolvency issues in financial markets and in the corporate sector it may ease liquidity pressures and it would signal that global policy makers are serious about addressing together this most extreme liquidity and financial crisis. Also, some of the radical policy actions that have been suggested here for the US will most likely need to be undertaken also by European policy makers as the liquidity and credit crisis is now becoming global.

an emergency triage between insolvent and illiquid and undercapitalized but solvent banks should be made;

a sharp reduction of the mortgage debt burden of the insolvent household sector;

and a recapitalization of solvent banks to be done via public injection of preferred shares and matching contributions by current shareholders of the banks.

Financial markets have already voted no to this plan (that is flawed in its current form) yesterday when after its passage in the Senate US and global equity markets plunged another 4% while money markets and credit markets seized up even further.

Conslusion

The suggested policy actions are extreme and radical but the times and conditions in financial markets and the corporate sector are also extreme. Thus, to avoid another Great Depression radical and unorthodox policy action needs to be taken now both in the US and in other advanced economies as the credit crisis and liquidity crisis is now becoming virulent even in Europe and other advanced economies.

This credit crisis is both a crisis of confidence and illiquidity and a crisis of credit and solvency. But while the insolvent institutions should go bust we have now reached a point where many financial institutions and now non financial firms may become insolvent because of pure illiquidity; and this would lead to an extremely severe economic contraction similar to an economic depression rather than a mild recession.

At this point the US, the advanced economies (and now likely even some emerging market economies) will experience an ugly recession and an ugly financial and banking crisis regardless of what we do from now on. What radical policy action can only do is preventing what will now be an ugly and nasty two-year recession and financial crisis from turning into a systemic meltdown and a decade long economic depression. The financial and economic conditions are extreme; thus extreme policy action is needed now to save the global economy from an ugly depression.

{end Prof Roubini’s article}

Afterword

If you are new to this site, please glance at the archives below. You may find answers to your questions in these, such as the causes of the present crisis. I have been writing about these events for several years; since November 2007 on this site. As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below. Please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

This crisis has long been forecast by many, including in articles on this site. Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results. To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime. Here are some of those posts.

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the lack of reg. capital has been a major contributor to the liquidity crisis. the govt needs to recapitalize all major financial institutions. ideally you would like to see further consolidation but we may nbot have time. preferred shares need to be purchased with a predetermined payback schedule.

Point 3 is completely inaccurate. While there are problems with Financial and Asset-Backed Commercial Paper, there are few problems with Non-Financial Commercial Paper. See the Fed’s own Commercial Paper statistics at http://www.federalreserve.gov/releases/cp/default.htm
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.Fabius Maximus replies: How strange it is that people make such wild claims, with so little basis in fact.

Your basis for this strong statement is “there are few problems with Non-Financial Commercial Paper”. Let’s take this by the numbers. First, instead of the Fed graphs to which you link let’s use the tables (same report) here.

(1) Roubini says “financial paper accounted for most of the decline, plunging $64.9 billion, or 8.7% in the last week” (the weekly report gives Wednesday totals). Is this correct? Yes.

FYI — Non-financial commercial paper (CP) is only 12% of the total. And even this little piece is down 9% over the past 3 weeks, reflecting tightening of the markets.

(2) Roubini says “but now even non-financial corporations are also experiencing severe roll-off in the CP market.” Now being the last few days, Wed-Friday. We will not see the result until next week’s numbers. If there is a relatively large decline, will you post an apology to Prof Roubini?

FYI — This report gives total outstanding, not paper issued. So even with no paper issued, the total declines relatively slowly — as paper matures (or, unfortunately, defaults).

I can’t imagine anyone capable of adding to Prof. Roubini’s analysis and it is comforting to see what has happened at this site over the past few weeks in that direction. While this may seem overly simplistic and philosophical in a way that is not appealing to current thought modes, I think it needs to be stated and this is the time.

One concept that absolutely has to be kept in mind as this culture attempts to reconfigure its financial system is that *complexity is vulnerability.* This may seem intuitively obvious and perhaps it is, but this is more than an old saw (keep it simple stupid) and not simply about appealing to more people or something like that. It is instead a proven scientific principle. It was I believe back in the 1990s that some scholars at MIT proved this mathematically by showing that the larger a network of toothpicks became, the fewer individual toothpicks being removed would make sections of that network disjoint.

Given that greed was in many ways the underlying problem here, and that it is a human appetite or aspect that needs to be constrained, I think it is useful to note that one if the best ways for it to operate is to create murkiness, complexity, lack of transparency, a set of new definitions and interdependencies that makes the average person’s hair hurt and is thus harder to regulate, to understand, to unravel when it all goes to hell. The Gordian Ponzi scheme of mortgage backed securities, derivatives, credit default swaps and the like is a prime example. The interdependencies and mathematics and models are so complex and circular that value at risk, and value in general, are somewhere between incomprehensible and incalculable.

Perhaps there is a role for Sarah Palin in the government after all. Going forward, all financial systems must be comprehensible and explicable in plain English by her or someone like her. In the meantime take it from this neo-Pythagorean and those scholars at MIT:

Complexity is vulnerability in all domains. It must be kept to the minimum necessary. You have been warned;-)>

Haven’t we crossed the threshold? Even if we tried to do all the things you suggest, who would buy the debt to pay for it? Don’t forget our creditors are now going to be short of cash as our purchases of oil and goods from them plummets. How can they manage to continue to purchase the debt that would be needed to fund these radical steps? If not, will we just start the printing presses at maximal speed?
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.Fabius Maximus replies: From our foreign creditors, whose nations have very high savings rates. I discuss this in:

There is plenty to be gloomy about; on the other hand, I do think our gracious host is on to something when he references the adaptability of Americans. It is a thing we have done well despite our shortcomings. Even recently, we have seen the public alter its behavior around driving and gasoline to good effect. Congresscritters are sounding more reasonable day by day, and the election polls more and more reflect the policies of the candidates in proportion to their probable ability to improve things. It ain’t gonna be easy, but it ain’t impossible. Watch for a post-election, even inauguration, speech from Obama that stresses sacrifice, austerity and non-ideological citizen involvement… something VERY serious. He’s already nearly there. I am betting on this… in ten dollar increments for those interested;-).

I merely gave you the link to the Federal Reserve’s site. I expected you to examine the entire site and to draw your own conclusions. Did you not notice the volume statistics? Upon further reflection, I should have stated, “not entirely accurate,” rather than “completely inaccurate.” Yes, the actual numbers he stated are accurate, however they do not tell the entire story. He is spinning it to make it look worse than it really is. No, I will not apologize. I believe Roubini is too anxious to be proven right after being regarded as a nutcase for so many years.
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.Fabius Maximus replies: You ignore the primary point I made. The Fed data ends Wednesday. Roubini is describes events taking place NOW — the Wednesday thru Friday period. You have no data for that, so your fierce conclusions are totally unsupported at this time. Next week we can see who is correct.

Thanks for replying to my comment above. While I applaud your rational approach, I think it is highly unlikely that our creditor countries will be able to help us much, even though they might want to. Their economies are already dropping into severe recession and they are going to need every bit of their resources in order to prevent civil unrest as conditions deteriorate over the coming months. Massive deflation is underway worldwide. Money and credit are scarce. Deflation is always hardest on those who are most in debt -and we are the world’s largest debtor country. I would love to hear your opinion on the above.
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.Fabius Maximus replies: You might be correct. I don’t speculate on the odds of this happening.

its very important to understand how spending takes place at the federal level when we are not on the gold standard and have a fiat currency and a flexible exchange rate.
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.Fabius Maximus replies: Please note that the comment policy requires they be brief, civil, and related to the post. This is not. No more, please.

Huge deflation coming. We have some $12 trillion in outstanding mortgage debt. Nobody knows how much those houses are worth.

I guess 50% — so maybe the $12 trillion should be converted to $6 trillion–reducing the home owner debt by $6 trillion, and the wealth of US and global investors by $6 trillion. Those that get their cash out of financial companies now might not see their wealth halved.
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.Fabius Maximus replies: Fortunately this is wrong on multiple levels.

First, I doubt that national US home prices will decline by 1/2 from the peak. In many areas they rose only slowly. Rural areas, much of the midwest and NE. I have seen some pessimistic expert forecasts, but nothing like 50% down.

Second, most owners have equity. So a price decline does not mean that they have negative equity and will default on their mortgages.

Third, most home owners have jobs. So even negative equity does not mean that they will default on their homes and move into a rental (very few Americans can afford to buy a home for cash).

Fourth, I suspect that accellerating mortgage defaults will spur creation of a modern version of the Home Owners Loan Corporation, which during the 1930’s owned (from memory) aprox 1/5 of US home mortgages. I have recommended this in several posts, and others (e.g. Prof Roubini) have also done so.

Today the Fed announced that is it doing 1 above, making direct unsecured loans to non-financial companies (e.g., buying their commercial paper). I see no alternatives at this time. This is good news, but will require massive funding to have the necessary effect.